WHAT HAPPENS WHEN YOU ADD AN EXTRA $3000 BILLION TO THE BALANCE SHEET?

Nov 15, 2017

Karen Clarke, Area Vice President EMEA, Anaplan

Listed companies need to implement the IFRS 16 new lease accounting standard rapidly. Long-term leasing of buildings, equipment and patents will have to be recorded on the balance sheet.

The role of the balance sheets is to provide a true and accurate picture of a company’s financial health. Unfortunately, this isn’t always the case, resulting in unpleasant surprises among listed companies. Investors sometimes discover, rather late in the day, the equivalent of a long-term debt that is damaging to their company’s value. A famous example is the bankruptcy of the US Borders Group bookstore chain in 2011, which had not recorded its store leasing commitments on the balance sheet; commitments that totalled $2.8 billion, or seven times it’s registered liability on the company balance sheet.

After the dot.com bubble burst in the early 2000s, the real debts of some telecom providers came as a surprise. In itself, the 2008 financial crisis raised a lot of questions about company valuation. If a company’s worth is calculated by the sum of its market capitalisation, plus its long-term debt, less the available cash, taking into account off-balance-sheet debt can have harmful impact/ damaging effects on both the quoted share value and valuation of the debt on the secondary market.

Look at the account statements of listed companies and eventually you’ll find a list of off-balance-sheet commitments. According to Bloomberg, these total a global sum of $3000 billion.

This is not an entirely negligible amount. The new IFRS 16 standard, which will give investors more visibility, takes effect from January 2019. The IFRS 16 changes accounting methods for leasing contracts. Instead of just recording a leasing expense, the lease will be replaced by a liability and an equivalent asset and (corresponding to the acquisition of this asset). Retailers and hoteliers who do not own their premises will be strongly impacted, along with transport companies, including airlines, railways and haulers that lease rather than own their aircraft, vehicles, trucks, railcars, containers etc. Any company leasing large equipment (BTP, mining, oil or gas exploration) will have to conform. Even companies that lease and manage patent portfolios.

Although the IFRS 16 standard takes effect from 1st January 2019, many organisations need to understand its impact in advance, to benefit from a timely comparative assessment for 2018 at the very least. Developing a proactive strategy by late 2017 or early 2018 will be key.

One thing is sure, your business will be affected. With IFRS 16 you will have to do more than simply convert your operating lease commitments to take into consideration lease assets and liabilities. Procurement, processes, lease administration, tax treatment, negotiation of contract and policies have to be reviewed. Multiple lines of business will need to work together to ensure a smooth transition. The office of the CFO will be at the center of this transformation, being the trusted business partner of Accounting, HR and Operations. A good IT system is paramount to succeed, and it could be an opportunity to embrace the change and adopt modern technologies.

Unfortunately, those who are dependent on ageing technologies will either have to wait or invest a great deal of money to ensure compliance. A simple spreadsheet will clearly not be enough, as the new measures may prove rather complex to implement.

The most effective solution will be cloud-based and naturally collaborative, able to connect the leasing plan for tangible and intangible assets to their impact on the Balance Sheet and Profit and Loss Account.

For a global company, IFRS 16 doesn’t require the centralisation of every lease procurement, lease administration and lease accounting functions that are located in different countries. However, a consolidated view has to be put in action. Companies relying on spreadsheets face significant challenges. Most legacy software vendors only have an IFRS 16 roadmap (not a solution yet but a promise to have one), or solutions that are very expensive to implement.

New financial complexities will also have to be dealt with. For example, a contract may include lease and non-lease component. Companies pay monthly for the use of an office and, at the same time, for the maintenance services. Up until now, this was bundle in a single contract. With IFRS 16, organisations will have to separate the two components in order to avoid increasing the lease obligation on your balance sheet. Investors will want to see accuracy, not an overweight statement.

Another item to consider is additional tax related considerations, since lease accounting changes will have an impact on existing tax positions. Businesses will have to make adjustments to defer taxes and be able to track or book tax differences. Cloud-based tax reporting technology could be leveraged to offer more transparency about tax principles, tax data and the taxes paid per country, which are all also greatly appreciated by investors and tax collectors.

Time is running out fast and agility is the key to becoming compliant on time. Reportwise, a European Consulting firm, built an IFRS 16 application on the Anaplan Platform. “It can be configured very quickly, from 5 to 20 days, to meet the needs of a company”, says Michel Morel, partner of Reportwise. He recommends first to do an inventory of the leasing contracts and then to carry out a simulation of the impact on the balance sheet and the profit and loss account at the date of transition. “This will allow the CFO to choose the best option for reprocessing the past, explains Michel Morel. With the Anaplan Platform, it will be easy to manage the evolution of leases and the implementation of new ones”.

Agile tools will help companies to deal with changes in their current leasing contracts as well as implement new ones. This way, they will also be able to demonstrate to their investors that they made an informed choice between rental and purchase. Today, having the right tools available to demonstrate this to investors is not a luxury. It’s a necessity.